The Principles of Political Economy, by John Stuart Mill

Chapter 12

Influence of Credit on Money

§1. Having now formed a general idea of the modes in which credit is made available as a substitute for money, we
have to consider in what manner the use of these substitutes affects the value of money, or, what is equivalent, the
prices of commodities. It is hardly necessary to say that the permanent value of money — the natural and average prices
of commodities — are not in question here. These are determined by the cost of producing or of obtaining the precious
metals. An ounce of gold or silver will in the long run exchange for as much of every other commodity, as can be
produced or imported at the same cost with itself. And an order, or note of hand, or bill payable at sight, for an
ounce of gold, while the credit of the giver is unimpaired, is worth neither more nor less than the gold itself.

It is not, however, with ultimate or average, but with immediate and temporary prices, that we are now concerned.
These, as we have seen, may deviate very widely from the standard of cost of production. Among other causes of
fluctuation, one we have found to be, the quantity of money in circulation. Other things being the same, an increase of
the money in circulation raises prices, a diminution lowers them. If more money is thrown into circulation than the
quantity which can circulate at a value conformable to its cost of production, the value of money, so long as the
excess lasts, will remain below the standard of cost of production, and general prices will be sustained above the
natural rate.

But we have now found that there are other things, such as bank notes, bills of exchange, and cheques, which
circulate as money, and perform all the functions of it: and the question arises, Do these various substitutes operate
on prices in the same manner as money itself? Does an increase in the quantity of transferable paper tend to raise
prices, in the same manner and degree as an increase in the quantity of money? There has been no small mount of
discussion on this point among writers on currency, without any result so conclusive as to have yet obtained general
assent.

I apprehend that bank notes, bills, or cheques, as such, do not act on prices at all. What does act on prices is
Credit, in whatever shape given, and whether it gives rise to any transferable instruments capable of passing into
circulation, or not.

I proceed to explain and substantiate this opinion.

§2. Money acts upon prices in no other way than by being tendered in exchange for commodities. The demand which
influences the prices of commodities consists of the money offered for them. But the money offered, is not the same
thing with the money possessed. It is sometimes less, sometimes very much more. In the long run indeed, the money which
people lay out will be neither more nor less than the money which they have to lay out: but this is far from being the
case at any given time. Sometimes they keep money by them for fear of an emergency, or in expectation of a more
advantageous opportunity for expending it. In that case the money is said not to be in circulation: in plainer
language, it is not offered, nor about to he offered, for commodities. Money not in circulation has no effect on
prices. The converse, however, is a much commoner case; people make purchases with money not in their possession. An
article, for instance, which is paid for by a cheque on a banker, is bought with money which not only is not in the
payer’s possession, but generally not even in the banker’s, having been lent by him (all but the usual reserve) to
other persons. We just now made the imaginary supposition that all persons dealt with a bank, and all with the same
bank, payments being universally made by cheques. In this ideal case, there would be no money anywhere except in the
hands of the banker: who might then safely part with all of it, by selling it as bullion, or lending it, to be sent out
of the country in exchange for goods or foreign securities. But though there would then be no money in possession, or
ultimately perhaps even in existence, money would be offered, and commodities bought with it, just as at present.
People would continue to reckon their incomes and their capitals in money, and to make their usual purchases with
orders for the receipt of a thing which would have literally ceased to exist. There would be in all this nothing to
complain of, so long as the money, in disappearing, left an equivalent value in other things, applicable when required
to the reimbursement of those to whom the money originally belonged.

In the case however of payment by cheques, the purchases are at any rate made, though not with money in the buyer’s
possession, yet with money to which he has a right. But he may make purchases with money which he only expects to have,
or even only pretends to expect. He may obtain goods in return for his acceptances payable at a future time; or on his
note of hand; or on a simple book credit, that is, on a mere promise to pay. All these purchases have exactly the same
effect on price, as if they were made with ready money. The amount of purchasing power which a person can exercise is
composed of all the money in his possession or due to him, and of all his credit. For exercising the whole of this
power he finds a sufficient motive only under peculiar circumstances; but he always possesses it; and the portion of it
which he at any time does exercise, is the measure of the effect which he produces on price.

Suppose that, in the expectation that some commodity will rise in price, he determines, not only to invest in it all
his ready money, but to take up on credit, from the producers or importers, as much of it as their opinion of his
resources will enable him to obtain. Every one must see that by thus acting he produces a greater effect on price, than
if he limited his purchases to the money he has actually in hand. He creates a demand for the article to the full
amount of his money and credit taken together, and raises the price proportionally to both. And this effect is
produced, though none of the written instruments called substitutes for currency may be called into existence; though
the transaction may give rise to no bill of exchange, nor to the issue of a single bank note. The buyer, instead of
taking a mere book credit, might have given a bill for the amount; or might have paid for the goods with bank notes
borrowed for that purpose from a hanker, thus making the purchase not on his own credit with the seller, but on the
banker’s credit with the seller, and his own with the banker. Had he done so, he would have produced as great an effect
on price as by a simple purchase to the same amount on a book credit, but no greater effect. The credit itself, not the
form and mode in which it is given, is the operating cause.

§3. The inclination of the mercantile public to increase their demand for commodities by making use of all or much
of their credit as a purchasing power, depends on their expectation of profit. When there is a general impression that
the price of some commodity is likely to rise, from an extra demand, a short crop, obstructions to importation, or any
other cause, there is a disposition among dealers to increase their stocks, in order to profit by the expected rise.
This disposition tends in itself to produce the effect which it looks forward to, a rise of price: and if the rise is
considerable and progressive, other speculators are attracted, who, so long as the price has not begun to fall, are
willing to believe that it will continue rising. These, by further purchases, produce a further advance: and thus a
rise of price for which there were originally some rational grounds, is often heightened by merely speculative
purchases, until it greatly exceeds what the original grounds will justify. After a time this begins to be perceived;
the price ceases to rise, and the holders, thinking it time to realize their gains, are anxious to sell. Then the price
begins to decline: the holders rush into the market to avoid a still greater loss, and, few being willing to buy in a
falling market, the price falls much more suddenly than it rose. Those who have bought at a higher price than
reasonable calculation justified, and who have been overtaken by the revulsion before they had realized, are losers in
proportion to the greatness of the fall, and to the quantity of the commodity which they hold, or have bound themselves
to pay for.

Now all these effects might take place in a community to which credit was unknown: the prices of some commodities
might rise from speculation, to an extravagant height, and then fall rapidly back. But if there were no such thing as
credit, this could hardly happen with respect to commodities generally. If all purchases were made with ready money,
the payment of increased prices for some articles would draw an unusual proportion of the money of the community into
the markets for those articles, and must therefore draw it away from some other class of commodities, and thus lower
their prices. The vacuum might, it is true, be partly filled up by increased rapidity of circulation; and in this
manner the money of the community is virtually increased in a time of speculative activity, because people keep little
of it by them, but hasten to lay it out in some tempting adventure as soon as possible after they receive it. This
resource, however, is limited: on the whole, people cannot, while the quantity of money remains. the same, lay out much
more of it in some things, without laying out less in others. But what they cannot do by ready money, they can do by an
extension of credit. When people go into the market and purchase with money which they hope to receive hereafter, they
are drawing upon an unlimited, not a limited fund. Speculation, thus supported, may be going on in any number of
commodities, without disturbing the regular course of business in others. It might even be going on in all commodities
at once. We could imagine that in an epidemic fit of the passion of gambling, all dealers, instead of giving only their
accustomed orders to the manufacturers or growers of their commodity, commenced buying up all of it which they could
procure, as far as their capital and credit would go. All prices would rise enormously, even if there were no increase
of money, and no paper credit, but a mere extension of purchases on book credits. After a time those who had bought
would wish to sell, and prices would collapse.

This is the ideal extreme case of what is called a commercial crisis. There is said to be a commercial crisis, when
a great number of merchants and traders at once, either have, or apprehend that they shall have, a difficulty in
meeting their engagements. The most usual cause of this general embarrassment, is the recoil of prices after they have
been raised by a spirit of speculation, intense in degree, and extending to many commodities. Some accident which
excites expectations of rising prices, such as the opening of a new foreign market, or simultaneous indications of a
short supply of several great articles of commerce, sets speculation at work in several leading departments at once.
The prices rise, and the holders realize, or appear to have the power of realizing, great gains. In certain states of
the public mind, such examples of rapid increase of fortune call forth numerous imitators, and speculation not only
goes much beyond what is justified by the original grounds for expecting rise of price, but extends itself to articles
in which there never was any such ground: these, however, rise like the rest as soon as speculation sets in. At periods
of this kind, a great extension of credit takes place. Not only do all whom the contagion reaches, employ their credit
much more freely than usual; but they really have more credit, because they seem to be making unusual gains, and
because a generally reckless and adventurous feeling prevails, which disposes people to give as well as take credit
more largely than at other times, and give it to persons not entitled to it. In this manner, in the celebrated
speculative year 1825, and at various other periods during the present century, the prices of many of the principal
articles of commerce rose greatly, without any fall in others, so that general prices might, without incorrectness, be
said to have risen. When, after such a rise, the reaction comes, and prices begin to fall, though at first perhaps only
through the desire of the holders to realize, speculative purchases cease: but were this all, prices would only fall to
the level from which they rose, or to that which is justified by the state of the consumption and of the supply. They
fall, however, much lower; for as, when prices were rising, and everybody apparently making a fortune, it was easy to
obtain almost any amount of credit, so now, when everybody seems to be losing, and many fail entirely, it is with
difficulty that firms of known solidity can obtain even the credit to which they are accustomed, and which it is the
greatest inconvenience to them to be without; because all dealers have engagements to fulfil, and nobody feeling sure
that the portion of his means which he has entrusted to others will be available in time, no one likes to part with
ready money, or to postpone his claim to it. To these rational considerations there is superadded, in extreme cases, a
panic as unreasoning as the previous overconfidence; money is borrowed for short periods at almost any rate of
interest, and sales of goods for immediate payment are made at almost any sacrifice. Thus general prices, during a
commercial revulsion, fall as much below the usual level, as during the previous period of speculation they have risen
above it: the fall, as well as the rise, originating not in anything affecting money, but in the state of credit; an
unusually extended employment of credit during the earlier period, followed by a great diminution, never amounting
however to an entire cessation of it, in the later.

It is not, however, universally true that the contraction of credit, characteristic of a commercial crisis, must
have been preceded by an extraordinary and irrational extension of it. There are other causes; and one of the more
recent crises, that of 1847, is an instance, having been preceded by no particular extension of credit, and by no
speculations; except those in railway shares, which, though in many cases extravagant enough, yet being carried on
mostly with that portion of means which the speculators could afford to lose, were not calculated to produce the
widespread ruin which arises from vicissitudes of price in the commodities in which men habitually deal, and in which
the bulk of their capital is invested. The crisis of 1847 belonged to another class of mercantile phenomena. There
occasionally happens a concurrence of circumstances tending to withdraw from the loan market a considerable portion of
the capital which usually supplies it. These circumstances, in the present case, were great foreign payments,
(occasioned by a high price of cotton and an unprecedented importation of food,) together with the continual demands on
the circulating capital of the country by railway calls and the loan transactions of railway companies, for the purpose
of being converted into fixed capital and made unavailable for future lending. These various demands fell principally,
as such demands always do, on the loan market. A great, though not the greatest part of the imported food, was actually
paid for by the proceeds of a government loan. The extra payments which purchasers of corn and cotton, and railway
shareholders, found themselves obliged to make, were either made with their own spare cash, or with money raised for
the occasion. On the first supposition, they were made by withdrawing deposits from bankers, and thus cutting off a
part of the streams which fed the loan market; on the second supposition, they were made by actual drafts on the loan
market, either by the sale of securities, or by taking up money at interest. This combination of a fresh demand for
loans, with a curtailment of the capital disposable for them, raised the rate of interest, and made it impossible to
borrow except on the very best security. Some firms, therefore, which by an improvident and unmercantile mode of
conducting business had allowed their capital to become either temporarily or permanently unavailable, became unable to
command that perpetual renewal of credit which had previously enabled them to struggle on. These firms stopped payment:
their failure involved more or less deeply many other firms which had trusted them; and, as usual in such cases, the
general distrust, commonly called a panic, began to set in, and might have produced a destruction of credit equal to
that of 1825, had not circumstances which may almost be called accidental, given to a very simple measure of the
government (the suspension of the Bank Charter Act of 1844) a fortunate power of allaying panic, to which, when
considered in itself, it had no sort of claim.1

§4. The general operation of credit upon prices being such as we have described, it is evident that if any
particular mode or form of credit is calculated to have a greater operation on prices than others, it can only be by
giving greater facility, or greater encouragement, to the multiplication of credit transactions generally. If bank
notes, for instance, or bills, have a greater effect on prices than book credits, it is not by any difference in the
transactions themselves, which are essentially the same, whether taking place in the one way or in the other: it must
be that there are likely to be more of them. If credit is likely to be more extensively used as a purchasing power when
bank notes or bills are the instruments used, than when the credit is given by mere entries in an account, to that
extent and no more there is ground for ascribing to the former a greater power over the markets than belongs to the
latter.

Now it appears that there is some such distinction. As far as respects the particular transactions, it makes no
difference in the effect on price whether A buys goods of B on simple credit, or gives a bill for them, or pays for
them with bank notes lent to him by a banker C. The difference is in a subsequent stage. If A has bought the goods on a
book credit, there is no obvious or convenient mode by which B can make A’s debt to him a means of extending his own
credit. Whatever credit he has, will be due to the general opinion entertained of his solvency; he cannot specifically
pledge A’s debt to a third person, as a security for money lent or goods bought. But if A has given him a bill for the
amount, he can get this discounted, which is the same thing as borrowing money on the joint credit of A and himself: or
he may pay away the bill in exchange for goods, which is obtaining goods on the same joint credit. In either case, here
is a second credit transaction, grounded on the first, and which would not have taken place if the first had been
transacted without the intervention of a bill. Nor need the transactions end here. The bill may be again discounted, or
again paid away for goods, several times before it is itself presented for payment. Nor would it be correct to say that
these successive holders, if they had not had the bill, might have attained their purpose by purchasing goods on their
own credit with the dealers. They may not all of them be persons of credit, or they may already have stretched their
credit as far as it will go. And at all events, either money or goods are more readily obtained on the credit of two
persons than of one. Nobody will pretend that it is as easy a thing for a merchant to borrow a thousand pounds on his
own credit, as to get a bill discounted to the same amount, when the drawee is of known solvency.

If we now suppose that A, instead of giving a bill, obtains a loan of bank notes from a banker C, and with them pays
B for his goods, we shall find the difference to be still greater. B is now independent even of a discounter: A’s bill
would have been taken in payment only by those who were acquainted with his reputation for solvency, but a banker is a
person who has credit with the public generally, and whose notes are taken in payment by every one, at least in his own
neighbourhood: insomuch that, by a custom which has grown into law, payment in bank notes is a complete acquittance to
the payer, whereas if he has paid by a bill, he still remains liable to the debt, if the person on whom the bill is
drawn fails to pay it when due. B therefore can expend the whole of the bank notes without at all involving his own
credit; and whatever power he had before of obtaining goods on book credit, remains to him unimpaired, in addition to
the purchasing power he derives from the possession of the notes. The same remark applies to every person in
succession, into whose hands the notes may come. It is only A, the first holder, (who used his credit to obtain the
notes as a loan from the issuer,) who can possibly find the credit he possesses in other quarters abated by it; and
even in his case that result is not probable; for though, in reason, and if all his circumstances were known, every
draft already made upon his credit ought to diminish by so much his power of obtaining more, yet in practice the
reverse more frequently happens, and his having been trusted by one person is supposed to be evidence that he may
safely be trusted by others also.

It appears, therefore, that bank notes are a more powerful instrument for raising prices than bills, and bills than
book credits. It does not, indeed, follow that credit will be more used because it can be. When the state of trade
holds out no particular temptation to make large purchases on credit, dealers will use only a small portion of the
credit power, and it will depend only on convenience whether the portion which they use will be taken in one form or in
another. It is not until the circumstances of the markets, and the state of the mercantile mind, render many persons
desirous of stretching their credit to an unusual extent, that the distinctive properties of the different forms of
credit display themselves. Credit already stretched to the utmost in the form of book debts, would be susceptible of a
great additional extension by means of bills, and of a still greater by means of bank notes. The first, because each
dealer, in addition to his own credit, would be enabled to create a further purchasing power out of the credit which he
had himself given to others: the second, because the banker’s credit with the public at large, coined into notes, as
bullion is coined into pieces of money to make it portable and divisible, is so much purchasing power superadded, in
the hands of every successive holder, to that which he may derive from his own credit. To state the matter otherwise;
one single exertion of the credit-power in the form of book credit, is only the foundation of a single purchase: but if
a bill is drawn, that same portion of credit may serve for as many purchases as the number of times the bill changes
hands: while every bank note issued, renders the credit of the banker a purchasing power to that amount in the hands of
all the successive holders, without impairing any power they may possess of effecting purchases on their own credit.
Credit, in short, has exactly the same purchasing power with money; and as money tells upon prices not simply in
proportion to its amount, but to its amount multiplied by the number of times it changes hands, so also does credit;
and credit transferable from hand to hand is in that proportion more potent, than credit which only performs one
purchase.

§5. All this purchasing power, however, is operative upon prices, only according to the proportion of it which is
used; and the effect, therefore, is only felt in a state of circumstances calculated to lead to an unusually extended
use of credit. In such a state of circumstances, that is, in speculative times, it cannot, I think, be denied, that
prices are likely to rise higher if the speculative purchases are made with bank notes, than when they are made with
bills, and when made by bills than when made by book credits. This, however, is of far less practical importance than
might at first be imagined; because, in point of fact, speculative purchases are not, in the great majority of cases,
made either with bank notes or with bills, but are made almost exclusively on book credits. “Applications to the Bank
for extended discount,” says the highest authority on such subjects,2 (and the same thing must be true of applications to other banks) “occur rarely if ever in the
origin or progress of extensive speculations in commodities. These are entered into, for the most part if not entirely,
in the first instance, on credit, for the length of term usual in the several trades; thus entailing on the parties no
immediate necessity for borrowing so much as may he wanted for the purpose beyond their own available capital. This
applies particularly to speculative purchases of commodities on the spot, with a view to resale. But these generally
form the smaller proportion of engagements on credit. By far the largest of those entered into on the prospect of a
rise of prices, are such as have in view importations from abroad. The same remark, too, is applicable to the export of
commodities, when a large proportion is on the credit of the shippers or their consignees. As long as circumstances
hold out the prospect of a favourable result, the credit of the parties is generally sustained. If some of them wish to
realize, there are others with capital and credit ready to replace them; and if the events fully justify the grounds on
which the speculative transactions were entered into (thus admitting of sales for consumption in time to replace the
capital embarked) there is no unusual demand for borrowed capital to sustain them. It is only when by the vicissitudes
of political events, or of the seasons, or other adventitious circumstances, the forthcoming supplies are found to
exceed the computed rate of consumption, and a fall of prices ensues, that an increased demand for capital takes place;
the market rate of interest then rises, and increased applications are made to the Bank of England for discount.” So
that the multiplication of bank notes and other transferable paper does not, for the most part, accompany and
facilitate the speculation; but comes into play chiefly when the tide is turning, and difficulties begin to be
felt.

Of the extraordinary height to which speculative transactions can be carried upon mere book credits, without the
smallest addition to what is commonly called the currency, very few persons are at all aware. “The power of purchase,”
says Mr Tooke,3 “by persons having capital and credit, is much
beyond anything that those who are unacquainted practically with speculative markets have any idea of. . . .
A person having the reputation of capital enough for his regular business, and enjoying good credit in his trade, if he
takes a sanguine view of the prospect of a rise of price of the article in which he deals, and is favoured by
circumstances in the outset and progress of his speculation, may effect purchases to an extent perfectly enormous,
compared with his capital.” Mr Tooke confirms this statement by some remarkable instances, exemplifying the immense
purchasing power which may be exercised, and rise of price which may be produced, by credit not represented by either
bank notes or bills of exchange.

“Amongst the earlier speculators for an advance in the price of tea, in consequence of our dispute with China in
1839, were several retail grocers and tea-dealers. There was a general disposition among the trade to get into stock:
that is, to lay in at once a quantity which would meet the probable demand from their customers for several months to
come. Some, however, among them, more sanguine and adventurous than the rest, availed themselves of their credit with
the importers and wholesale dealers, for purchasing quantities much beyond the estimated demand in their own business.
As the purchases were made in the first instance ostensibly, and perhaps really, for the legitimate purposes and within
the limits of their regular business, the parties were enabled to buy without the condition of any deposit; whereas
speculators, known to be such, are required to pay 2l. per chest, to cover any probable difference of price which might
arise before the expiration of the prompt, which, for this article, is three months. Without, therefore, the outlay of
a single farthing of actual capital or currency in any shape, they made purchases to a considerable extent; and with
the profit realized on the resale of a part of these purchases, they were enabled to pay the deposit on further
quantities when required, as was the case when the extent of the purchases attracted attention. In this way, the
speculation went on at advancing prices (100 per cent and upwards) till nearly the expiration of the prompt, and if at
that time circumstances had been such as to justify the apprehension which at one time prevailed, that all future
supplies would be cut off, the prices might have still further advanced, and at any rate not have retrograded. In this
case, the speculators might have realized, if not all the profit they had anticipated, a very handsome sum, upon which
they might have been enabled to extend their business greatly, or to retire from it altogether, with a reputation for
great sagacity in thus making their fortune. But instead of this favourable result, it so happened that two or three
cargoes of tea which had been transhipped were admitted, contrary to expectation, to entry on their arrival here, and
it was found that further indirect shipments were in progress. Thus the supply was increased beyond the calculation of
the speculators: and at the same time, the consumption had been diminished by the high price. There was, consequently,
a violent reaction on the market; the speculators were unable to sell without such a sacrifice as disabLed them from
fulfilling their engagements, and several of them consequently failed. Among these, one was mentioned, whO having a
capital not exceeding 1200l. which was locked up in his business, had contrived to buy 4000 chests, value above
80,000l., the loss upon which was about 16,000l.

“The other example which I have to give, is that of the operation on the corn market between 1838 and 1842. There
was an instance of a person who, when he entered on his extensive speculations, was, as it appeared by the subsequent
examination of his affairs, possessed of a capital not exceeding 5000l., but being successful in the outset, and
favoured by circumstances in the progress of his operations, he contrived to make purchases to such an extent, that
when he stopped payment his engagements were found to amount to between 500,000l. and 600,000l. Other instances might
be cited of parties without any capital at all, who, by dint of mere credit, were enabled, while the aspect of the
market favoured their views, to make purchases to a very great extent.

“And be it observed, that these speculations, involving enormous purchases on little or no capital, were carried on
in 1839 and 1840, when the money market was in its most contracted state; or when, according to modern phraseology,
there was the greatest scarcity of money.”

But though the great instrument of speculative purchases is book credits, it cannot be contested that in speculative
periods an increase does take place in the quantity both of bills of exchange and of bank notes. This increase, indeed,
so far as bank notes are concerned, hardly ever takes place in the earliest stage of the speculations: advances from
bankers (as Mr Tooke observes) not being applied for in order to purchase, but in order to hold on without selling when
the usual term of credit has expired, and the high price which was calculated on has not arrived. But the tea
speculators mentioned by Mr Tooke could not have carried their speculations beyond the three months which are the usual
term of credit in their trade, unless they had been able to obtain advances from bankers, which, if the expectation of
a rise of price had still continued, they probably could have done.

Since, then, credit in the form of bank notes is a more potent instrument for raising prices than book credits, an
unrestrained power of resorting to this instrument may contribute to prolong and heighten the speculative rise of
prices, and hence to aggravate the subsequent recoil. But in what degree? and what importance ought we to ascribe to
this possibility? It may help us to form some judgment on this point, if we consider the proportion which the utmost
increase of bank notes in a period of speculation, bears, I do not say to the whole mass of credit in the country, but
to the bills of exchange alone. The average amount of bills in existence at any one time is supposed greatly to exceed
a hundred millions sterling.4 The bank note circulation of Great
Britain and Ireland seldom exceeds forty millions, and the increase in speculative periods at most two or three. And
even this, as we have seen, hardly ever comes into play until that advanced period of the speculation at which the tide
shows signs of turning, and the dealers generally are rather thinking of the means of fulfilling their existing
engagements, than meditating an extension of them: while the quantity of bills in existence is largely increased from
the very commencement of the speculations.

§6. It is well known that of late years, an artificial limitation of the issue of bank notes has been regarded by
many political economists, and by a great portion of the public, as an expedient of supreme efficacy for preventing,
and when it cannot prevent, for moderating, the fever of speculation; and this opinion received the recognition and
sanction of the legislature by the Currency Act of 1844. At the point, however, which our inquiries have reached,
though we have conceded to bank notes a greater power over prices than is possessed by bills or book credits, we have
not found reason to think that this superior efficacy has much share in producing the rise of prices which accompanies
a period of speculation, nor consequently that any restraint applied to this one instrument can be efficacious to the
degree which is often supposed, in moderating either that rise, or the recoil which follows it. We shall be still less
inclined to think so, when we consider that there is a fourth form of credit transactions, by cheques on bankers, and
transfers in a banker’s books, which is exactly parallel in every respect to bank notes, giving equal facilities to an
extension of credit, and capable of acting on prices quite as powerfully. In the words of Mr. Fullarton,5 “there is not a single object at present attained through the agency of
Bank of England notes, which might not be as effectually accomplished by each individual keeping an account with the
bank, and transacting all his payments of five pounds and upwards by cheque.” A bank, instead of lending its notes to a
merchant or dealer, might open an account with him, and credit the account with the sum it had agreed to advance: on an
understanding that he should not draw out that sum in any other mode than by drawing cheques against it in favour of
those to whom he had occasion to make payments. These cheques might possibly even pass from hand to hand like bank
notes; more commonly however the receiver would pay them into the hands of his own banker, and when he wanted the
money, would draw a fresh cheque against it: and hence an objector may urge that as the original cheque would very soon
be presented for payment, when it must be paid either in notes or in coin, notes or coin to an equal amount must be
provided as the ultimate means of liquidation. It is not so, however. The person to whom the cheque is transferred, may
perhaps deal with the same banker, and the cheque may return to the very bank on which it was drawn: this is very often
the case in country districts; if so, no payment will be called for, but a simple transfer in the banker’s books will
settle the transaction. If the cheque is paid into a different bank, it will not be presented for payment, but
liquidated by set-off against other cheques; and in a state of circumstances favourable to a general extension of
banking credits, a banker who has granted more credit, and has therefore more cheques drawn on him, will also have more
cheques on other bankers paid to him, and will only have to provide notes or cash for the payment of balances; for
which purpose the ordinary reserve of prudent bankers, one-third of their liabilities, will abundantly suffice. Now, if
he had granted the extension of credit by means of an issue of his own notes, he must equally have retained, in coin or
Bank of England notes, the usual reserve: so that he can, as Mr. Fullarton says, give every facility of credit by what
may be termed a cheque circulation, which he could give by a note circulation.

This extension of credit by entries in a banker’s books, has all that superior efficiency in acting on prices, which
we ascribed to an extension by means of bank notes. As a bank note of 20l., paid to any one, gives him 20l. of
purchasing-power based on credit, over and above whatever credit he had of his own, so does a cheque paid to him do the
same: for, although he may make no purchase with the cheque itself, he deposits it with his banker, and can draw
against it. As this act of drawing a cheque against another which has been exchanged and cancelled, can be repeated as
often as a purchase with a bank note, it effects the same increase of purchasing power. The original loan, or credit,
given by the banker to his customer, is potentially multiplied as a means of purchase, in the hands of the successive
persons to whom portions of the credit are paid away, just as the purchasing power of a bank note is multiplied by the
number of persons through whose hands it passes before it is returned to the issuer.

These considerations abate very much from the importance of any effect which can be produced in allaying the
vicissitudes of commerce, by so superficial a contrivance as the one so much relied on of late, the restriction of the
issue of bank notes by an artificial rule. An examination of all the consequences of that restriction, and an estimate
of the reasons for and against it, must be deferred until we have treated of the foreign exchanges, and the
international movements of bullion. At present we are only concerned with the general theory of prices, of which the
different influence of different kinds of credit is an essential part.

§7. There has been a great amount of discussion and argument on the question whether several of these forms of
credit, and in particular whether bank notes, ought to be considered as money. The question is so purely verbal as to
be scarcely worth raising, and one would have some difficulty in comprehending why so much importance is attached to
it, if there were not some authorities who, still adhering to the doctrine of the infancy of society and of political
economy, that the quantity of money compared with that of commodities, determines general prices, think it important to
prove that bank notes and no other forms of credit are money, in order to support the inference that bank notes and no
other forms of credit influence prices. It is obvious, however, that prices do not depend on money, but on purchases.
Money left with a banker, and not drawn against, or drawn against for other purposes than buying commodities, has no
effect on prices, any more than credit which is not used. Credit which is used to purchase commodities, affects prices
in the same manner as money. Money and credit are thus exactly on a par, in their effect on prices; and whether we
choose to class bank notes with the one or the other, is in this respect entirely immaterial.

Since, however, this question of nomenclature has been raised, it seems desirable that it should be answered. The
reason given for considering bank notes as money, is, that by law and usage they have the property, in common with
metallic money, of finally closing the transactions in which they are employed; while no other mode of paying one debt
by transferring another, has that privilege. The first remark which here suggests itself is, that on this showing, the
notes at least of private banks are not money; for a creditor cannot be forced to accept them in payment of a debt.
They certainly close the transaction if he does accept them; but so, on the same supposition, would a bale of cloth, or
a pipe of wine; which are not for that reason regarded as money. It seems to be an essential part of the idea of money,
that it be legal tender. An inconvertible paper which is legal tender is universally admitted to be money; in the
French language the phrase papier-monnaie actually means inconvertibility, convertible notes being merely billets a
porteur. It is only in the case of Bank of England notes under the law of convertibility, that any difficulty arises;
those notes not being a legal tender from the Bank itself, though a legal tender from all other persons. Bank of
England notes undoubtedly do close transactions, so far as respects the buyer. When he has once paid in Bank of England
notes, he can in no case be required to pay over again. But I confess I cannot see how the transaction can be deemed
complete as regards the seller, when he will only be found to have received the price of his commodity provided the
Bank keeps its promise to pay. An instrument which would be deprived of all value by the insolvency of a corporation,
cannot be money in any sense in which money is opposed to credit. It either is not money, or it is money and credit
too. It may be most suitably described as coined credit. The other forms of credit may be distinguished from it as
credit in ingots.

§8. Some high authorities have claimed for bank notes, as compared with other modes of credit, a greater distinction
in respect to influence on price, than we have seen reason to allow; a difference, not in degree, but in kind. They
ground this distinction on the fact, that all bills and cheques, as well as all book-debts, are from the first intended
to be, and actually are, ultimately liquidated either in coin or in notes. The bank notes in circulation, jointly with
the coin, are therefore, according to these authorities, the basis on which all the other expedients of credit rest;
and in proportion to the basis will be the superstructure; insomuch that the quantity of bank notes determines that of
all the other forms of credit. If bank notes are multiplied, there will, they seem to think, be more bills, more
payments by cheque, and I presume, more book credits; and by regulating and limiting the issue of bank notes, they
think that all other forms of credit are, by an indirect consequence, brought under a similar limitation. I believe I
have stated the opinion of these authorities correctly, though I have nowhere seen the grounds of it set forth with
such distinctness as to make me feel quite certain that I understand them. It may be true, that according as there are
more or fewer bank notes, there is also in general (though not invariably), more or less of other descriptions of
credit; for the same state of affairs which leads to an increase of credit in one shape, leads to an increase of it in
other shapes. But I see no reason for believing that the one is the cause of the other. If indeed we begin by assuming,
as I suspect is tacitly done, that prices are regulated by coin and bank notes, the proposition maintained will
certainly follow; for, according as prices are higher or lower, the same purchases will give rise to bills, cheques,
and book credits of a larger or a smaller amount. But the premise in this reasoning is the very proposition to be
proved. Setting this assumption aside, I know not how the conclusion can be substantiated. The credit given to any one
by those with whom he deals, does not depend on the quantity of bank notes or coin in circulation at the time, but on
their opinion of his solvency: if any consideration of a more general character enters into their calculation, it is
only in a time of pressure on the loan market, when they are not certain of being themselves able to obtain the credit
on which they have been accustomed to rely; and even then, what they look to is the general state of the loan market,
and not (preconceived theory apart) the amount of bank notes. So far, as to the willingness to give credit. And the
willingness of a dealer to use his credit, depends on his expectations of gain, that is, on his opinion of the probable
future price of his commodity; an opinion grounded either on the rise or fall already going on, or on his prospective
judgment respecting the supply and the rate of consumption. When a dealer extends his purchases beyond his immediate
means of payment, engaging to pay at a specified time, he does so in the expectation either that the transaction will
have terminated favourably before that time arrives, or that he shall then be in possession of sufficient funds from
the proceeds of his other transactions. The fulfilment of these expectations depends upon prices, but not especially
upon the amount of bank notes. He may, doubtless, also ask himself, in case he should be disappointed in these
expectations, to what quarter he can look for a temporary advance, to enable him, at the worst, to keep his
engagements. But in the first place, this prospective rejection on the somewhat more or less of difficulty which he may
have in tiding over his embarrassments, seems too slender an inducement to be much of a restraint in a period supposed
to be one of rash adventure, and upon persons so confident of success as to involve themselves beyond their certain
means of extrication. And further, I apprehend that their confidence of being helped out in the event of ill-fortune,
will mainly depend on their opinion of their own individual credit, with, perhaps, some consideration, not of the
quantity of the currency, but of the general state of the loan market. They are aware that, in case of a commercial
crisis, they shall have difficulty in obtaining advances. But if they thought it likely that a commercial crisis would
occur before they had realized, they would not speculate. If no great contraction of general credit occurs, they will
feel no doubt of obtaining any advances which they absolutely require, provided the state of their own affairs at the
time affords in the estimation of lenders a sufficient prospect that those advances will be repaid.

1 The commercial difficulties, not however amounting to a
commercial crisis, of 1864, had essentially the same origin. heavy payments for cotton imported at high prices, and
large investments in banking and other joint stock projects, combined with the loan operations of foreign governments,
made such large drafts upon the loan market as to raise the rate of discount on mercantile bills as high as nine per
cent.

4 The most approved estimate is that of Mr Leatham, grounded on
the official returns of bill stamps issued. The following are the results:—

Year

Bills created in Great Britain
and Ireland, founded on
returns of Bill Stamps
issued from the Stamp Office.

Average amount in circulation at one time in each year.

1832

£356,153,409

£89,038,352

1833

383,659,585

95,914,896

1834

379,155,052

94,788,763

1835

405,403,051

101,350,762

1836

485,943,473

121,485,868

1837

455,084,445

113,771,111

1838

465,504,041

116,376,010

1839

528,493,842

132,123.460

“Mr. Leatham,” says Mr. Tooke, “gives the process by which, upon the data furnished by the returns of stamps, he
arrives at these results; and I am disposed to think that they are as near an approximation to the truth as the nature
of the materials admits of arriving at.” — Inquiry into the Currency Principle, p. 26. Mr. Newmarch (Appendix No. 39 to
Report of the Committee on the Bank Acts in 1857, and History of Prices, vol. vi. p. 587) shows grounds for the opinion
that the total bill circulation in 1857 was not much less than 180 millions sterling, and that it sometimes rises to
200 millions.